Austrian Economics Forum Spring '12 #6--Fractional Reserve Banking?

The final session of the Spring Semester Austrian Economics Forum at NC State University cover the topic of Banking.  There are basically two camps in the Austrian School when it comes to banking—100% reserve banking and free banking with fractional reserves.  For this session we covered the article “Fractional Reserve Free Banking: Some Quibbles” by Philipp Bagus and David Howden in The Quarterly Journal of Austrian Economics (2010, vol. 13, no. 4, pp. 29-55) and Selgin’s response found here or here.

Personally, I am in the free banking camp, but I think that there are strong economic arguments for getting close to 100% reserves.  As I will explain below, it might be the case that while the objections to Fractional Reserve Free Banking (FRFB) are true, they might be so small that the positives outweigh the negatives.

Overall, I cannot express how disappointed I was with the Bagus and Howden article.  We have already covered Bagus’ book, The Tragedy of the Euro, in the first session this semester (here) and I thought the sections that we read were thin.  While there is a decent underlining argument there, the scholarship was weaker than what I was expecting.  Unfortunately, this article proved to have the same flaw—weak scholarship.  Furthermore, Howden gave a named lecture at the Mises Institute’s Austrian Scholar’s Conference.  He explained what he meant by a “quibble.”  He meant that the argument for free banking was so weak that to argue in favor of it is a mere quibble!  [Wow!] 

When presenting an argument of an opponent, one should always give the benefit of the doubt, define the terms in the most generous manner and cast it in the most favorable light.  If you can still destroy the argument, then your case is solid.  Unfortunately, this is not the approach that Bagus and Howden take in their article.  They assume narrow interpretations and unfavorable conditions.  Simply put, they are not generous to their opponents.  As a result, the FRFB side can point out that the overly narrow case does not apply and that the argument was misconstrued.  In the session, the criticism actually fell less on Bagus and Howden and more on the editorial staff and reviewers at the QJAE.  Basically, the sentiment was, “How did this article see the light of day?”

Due to the poor scholarship, Selgin is able to destroy their argument and make them look ridiculous and arrogant, which is too bad because Bagus and Howden are not dumb guys.  Let’s take a quick look at the exchange, from Selgin…

According to Bagus and Howden (2010, p. 36), “Selgin starts his analysis by assessing changes in the demand for money, not distinguishing between the demand for commodity money (money proper) and money substitutes.” Actually, my chapter concerning how free banks deal with changes in the demand for money is titled “Changes in the Demand for Inside Money” (my emphasis), where “inside money” means more or less the same thing as Bagus and Howden’s “money substitutes.”

It is simple points such as these that allow Selgin to skewer Bagus and Howden.  It is as if they simply did not take the time to understand Selgin’s argument.  If this was an isolated incident, maybe we can let that slide by, but it is unrelenting.  Bagus and Howden are simply misrepresenting the FRFB argument. 

Last summer, I finished reading Rothbard’s Conceived in Liberty, which is a history of the American Revolution.  From there I was propelled into reading Rothbard’s A History of Money and Banking in the United States.  Then in the Fall I had to teach a Money and Banking Class and so I reread and then assigned Rothbard’s The Mystery of Banking, The Case Against the Fed, The Case for a100% Gold Dollar, and What Has Government Done to Our Money?  To round myself off for this year, I read through White’s Free Banking in Britain, Selgin’s The Theory of Free Banking and Sechrest’s Free Banking.  (I also read, a while ago, Horwitz’s Microfoundations and Macroeconomics.)  So I have been getting myself grounded for the 100% Reserve versus FRFB roundtable panel at FEE’s Introduction to Austrian Economics Summer Seminar (link here).

So here is my analysis (take away) from the ongoing exchange.  First, I think that those who support the Free Banking position are better debaters than those on the 100% Reserve side.  I say this because it seems that the 100%ers are willing to fall back to the moral argument as opposed to fighting on economic ground.  While there is nothing inherently wrong in arguing against the legitimacy of converting a bailment into a deposit (an asset for the bank), my point is that it is not an economic argument.

The Bagus and Howden article does identify the weak points of the FRFB position, but they discredit their position against FRFB with their sloppy scholarship.  There are two major (economic) weaknesses in the FRFB position and it is due to these weaknesses that I have strong reservations on the FRFB position.

Before we can get into these points, we first need to make the distinction between the different types of credit.  A problem in the literature is that it seems that each author has his own way of defining credit and thus the arguments become confusing.  I will use the definitions Machlup uses in The Stock Market, Credit and Capital Formation (1931).  He distinguishes between transfer credit and created credit.  (While there is a third category, we don’t need to worry about it here.)

Transfer credit is the sort that stems from my placing money into a loaning institution and it is borrowed by another.  This form of a loan matches the deposit banking that Rothbard outlines in The Mystery of Banking.  The second type of credit is the sort that materializes out of nowhere.  An example of this is when the Federal Reserve buys a bond and credits the sellers account.  Where did that new money come from?  It came from a big, black hole of nothingness.  The money (credit) was created.

So the first weakness in Selgin’s presentation of the FRFB system is that he starts his analysis with an economy, and a banking system, that is fully loaned up.  In other words, he is starting with banks balancing their “average net reserve demand” equal to zero. (Selgin 1988, p. 73)  I think that this is a weakness, not because of the logic that Selgin engages in, but because that this assumes way a major point of credit fueled inflation—the process to get to a fully loaned up system.  I think that it is true that if we start with a fully loaned up banking system with no malinvestments, then yes, the system is fairly stable.  However, if in the process of getting to this fully loaned up state, we create malinvestments along the way, then the system is not stable.  There will be the classic Austrian Boom/Bust Cycle.

The next weakness that is found in the FRFB system centers on the precautionary reserves.  If the banking system is fully loaned up, it is vulnerable to any fluctuations in people’s willingness to hold on to cash (or not hold onto cash).  Thus, each bank will hold onto some reserves to insulate itself from the day-to-day fluctuations and from any unforeseen changes in market conditions.  The bank will lose money if it holds onto too much cash reserves and put itself at risk if it holds onto too few.  So far, so good.  This choice is an entrepreneurial one and markets should be able to handle this. 

So here is my concern.  Suppose that for whatever reason there is an increase in the demand to hold onto cash.  This holding onto cash is deferred consumption.  In other words, it is saving.  Now, if nothing else happens there is a decrease in the demand for the goods and services that the cash holders are choosing not to buy.  This change in demand will then spread throughout the economy and the relative price changes will signal to entrepreneurs how to re-coordinate the economy. 

Many who support FRFB system (like Selgin and Horwitz) argue that this savings can be converted into transfer credit.  If the cash holders are holding onto an additional $1,000 per time period (e.g., each month), then the banks can loan out that additional sum of $1,000.  They argue that this is merely transfer credit and not created credit.  Therefore, this is not a problem to worry about.  While, it is true that this is not created credit, because the cash holders are indeed saving, there are, however, a few concerns.

First, as soon as these cash holders revert to their prior spending/cash holding patterns, then the banks need to call in those loans.  In the example above, the banks need to call in the $1,000.  Calling in loans may create a large disruption in the economic patterns.  If a business started a project and the loan is called in, there is no effective difference between liquidating this sort of a project and liquidating a malinvestment from an artificial boom.

Secondly, when the loan is made, there are nonneutral economic effects that stem from this loan.  When businessman A gets the loan, he will create a spending pattern that is unique.  New equilibria are generated.  This pattern will necessarily be different from the pattern generated by the reduction in demand by the saver.  While this may not seem to big a major problem to a well functioning economy, it is a point of concern to the extent that these patterns are at odds with the savers.  Most likely, the extent of concern on this point seems to be an empirical matter. 

The 100%ers are assuming that prices are flexible and will quickly adjust.  The FRFB supporters are assuming that prices are not quite as flexible and so they convert the savings into transfer credit.  However, to me this seems to be compounding the problem instead of solving it.  If prices adjust slowly, then why are we creating a second pattern to overlay which will reinforce or offset the prior pattern generated from savings?  I think that prices are stickier as we get closer to consumers.  While gasoline prices change by the penny each day, most consumer items target price points (e.g., $9.99, $29.99, etc.).  As we move further away from the consumer, we see less fixation on price points, but we do see more longer term contracts.  Again, this is a call for further research.  I suspect that there is some economic research on this, but since the other schools of economic thought tend to ignore the structure of production, I doubt that the answers are readily available.  If someone has a suggestion of where to look, I would be interested in these sources.